Edited version of private ruling

Authorisation Number: 1011673708025

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Ruling

Subject: Australian taxation implications of proposed lease transactions

Issue 1

Question 1.1

Will the Sub-Lessor be liable to pay income tax on the rent payable by the Lessee under the Sub-Lease pursuant to subsection 128B(5A) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

Question 1.2

Will the Head Lessor be liable to pay income tax on rental income derived under the Head Lease between the Head Lessor and Sub-Lessor pursuant to subsection 128B(5A) of the ITAA 1936?

Answer

No.

Issue 2

Question 2.1

Will the Sub-Lessor be treated as having a permanent establishment for the purposes of the applicable Business Profits Article of the relevant double tax agreement and accordingly have a liability for Australian income tax in respect of the rental income pursuant to section 6-5 of the Income Tax Assessment Act 1997 "ITAA 1997)?

Answer

No.

Question 2.2

Will the rental income derived by the Head Lessor under the Head Lease be deemed to be Australian sourced by virtue of the applicable double tax agreement and accordingly be subject to Australian income tax pursuant to section 6-5 of the ITAA 1997?

Answer

Yes.

Issue 3

Question 3.1

Will the Head Lessor be entitled to claim a tax deduction for the decline in value of the substantial equipment pursuant to section 40-25 of the ITAA 1997?

Answer

Yes.

Issue 4

Question 4.1

Will the Head Lessor be entitled to claim a deduction for the interest component of the hire-purchase payments made to the Financier under the Finance Lease (subject to the Australian thin capitalisation provisions) pursuant to section 8-1 of the ITAA 1997?

Answer

Yes.

Question 4.2

Will the Head Lessor be entitled to claim a tax deduction under section 8-1 of the ITAA 1997 for expenditure it incurred on revenue account in relation to the leasing of the substantial equipment, being legal costs associated with negotiating and drafting the lease agreements and management costs?

Answer

Yes.

Issue 5

Question 5.1

Will the Commissioner exercise the discretion under paragraph 177F(1)(a) of the ITAA 1936 to cancel a tax benefit obtained of a kind referred to in that paragraph, or that would but for section 177F of the ITAA 1936 be obtained, by the relevant taxpayer in connection with any of the following schemes:

a) the Head Lease from the Head Lessor to the Sub-Lessor?

b) the Sub-Lease from the Sub-Lessor to the Lessee?

c) the Head Lease from the Head Lessor to the Sub-Lessor and Sub-Lease from the Sub-Lessor to the Lessee?

Answer

a) No.

b) No.

c) No.

Question 5.2

Will the Commissioner exercise the discretion under paragraph 177F(1)(b) of the ITAA 1936 to cancel a tax benefit that is referable to a deduction allowable, or that would but for section 177F of the ITAA 1936 be allowable, to the relevant taxpayer in connection with either of the following schemes:

a) the Head Lease from the Head Lessor to the Sub-Lessor?

b) the Head Lease from the Head Lessor to the Sub-Lessor and Sub-Lease from the Sub-Lessor to the Lessee

Answer

a) No.

b) No.

Question 5.3

Will the Commissioner exercise the discretion under subsection 177F(2A) of the ITAA 1936 to cancel a tax benefit that is covered by section 177CA of the ITAA 1936 obtained, or that would but for section 177F of the ITAA 1936 be obtained, by the relevant taxpayer in connection with any of the following schemes:

a) the Head Lease from the Head Lessor to the Sub-Lessor?

b) the Sub-Lease from the Sub-Lessor to the Lessee?

c) the Head Lease from the Head Lessor to the Sub-Lessor and Sub-Lease from the Sub-Lessor to the Lessee?

Answer

a) No.

b) No.

c) No.

This ruling applies for the following periods:

1 January 2012 to 31 December 2012

1 January 2013 to 31 December 2013

1 January 2014 to 31 December 2014

1 January 2015 to 31 December 2015

1 January 2016 to 31 December 2016

1 January 2017 to 31 December 2017

1 January 2018 to 31 December 2018

1 January 2019 to 31 December 2019

1 January 2020 to 31 December 2020

1 January 2021 to 31 December 2021

1 January 2022 to 31 December 2022

1 January 2023 to 31 December 2023

1 January 2024 to 31 December 2024

The scheme commences on:

1 January 2012

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

An Australian resident Lessee intends to lease substantial equipment. The lease arrangement is as follows;

The non-resident Head-Lessor and non-resident Sub-Lessor are wholly owned subsidiaries of a non-resident Leasing Company (referred to collectively as 'the Lessors', where required).

The non-resident Head-Lessor is a resident of Country A and is entitled to the benefits conferred by a double tax agreement between Australia and Country A (Country A DTA).

The non-resident Sub-Lessor is a resident of Country B and is entitled to the benefits conferred by a double tax agreement between Australian and Country B (Country B DTA).

The Australian resident lessee will sub-lease the substantial equipment to related Australian resident sub-lessees. The terms of the sub-lease will be negotiated on arm's length basis.

The Australian resident Lessee will use the substantial equipment wholly in gaining or producing assessable income by way of sub-leasing the substantial equipment for lease rentals. The Sub-Lessees will use the substantial equipment wholly in gaining or producing assessable income.

Delivery of the substantial equipment will take place outside Australia.

The purchase price of the substantial equipment represents an arm's length market price and will be paid through a combination of:

§ payments paid by the Purchasing Company, and

§ proceeds from a finance arrangement.

The Purchasing Company is a wholly owned subsidiary of the non-resident Leasing Company. The Purchasing Company is a resident of Country C.

On the delivery date, the Purchasing Company will assign its right to acquire the Substantial equipment to the Financier.

The Financier is a resident of and incorporated in Country D. It is not a related entity of the Lessors or the Lessee.

Part of the purchase price of the substantial equipment will be funded by the Financier and guaranteed by the Guarantor.

The Guarantor requires as a pre-condition to the guarantee that the legal title in the substantial equipment be held by the Financier and that the Financier reside in a jurisdiction where the Guarantor is familiar with the legal structure.

The Lessors have entered into similar financing arrangements in the past.

The Financier will enter into the Finance Lease to the Head-Lessor for the same period as the Head Lease to the Sub-Lessor and subsequently Sub-Lease to Lessee. The Finance Lease will be negotiated and executed outside Australia. The Finance Lease will contain an option for the Head Lessor to purchase the substantial equipment at the expiry of the Finance Lease for nominal consideration. The Head Lessor intends to exercise its option to purchase the substantial equipment at the expiry of the Finance Lease given the nominal exercise price.

The Finance Lease from the Financier to the Head Lessor constitutes a hire purchase agreement as defined in subsection 995-1(1) of the ITAA 1997.

Under the Finance Lease, Head Lessor will have all the benefits and burdens of ownership.

The Head Lessor will lease the substantial equipment to the Sub-Lessor under the Sub-Lease.

The Sub-Lessor does not have an office or employees in Australia. It does not already have substantial equipment located within Australia available for lease in Australia (and which are used within Australia).

Rental payments received by Sub-Lessor (the rental income) will be paid by the Lessee directly into the Sub-Lessor's bank account outside Australia. No other activities of the Sub-Lessor other than the receipt of rental payments under the Sub-Lease arise in Australia. The Sub-Lessor will not undertake any repairs or maintenance of the substantial equipment during the lease term.

The Sub-Lessor will not operate the substantial equipment.

Country B is often used by the Leasing Company to Sub-Lease substantial equipment.

All lease negotiations between the Lessors and the Lessee are undertaken outside of Australia. The Head Lease and Sub-Lease will be executed outside Australia, effective from the date of delivery of the substantial equipment.

The terms of the Head Lease will be similar in all material respects to the terms of the Sub-Lease and the Lease terms are standard within the industry. The key Lease terms include;

§ The rental payments are negotiated on an arm's length basis with reference to normal commercial terms and reflect the market value of the substantial equipment leased in the current environment.

§ No restrictions are placed on the use of the substantial equipment other than certain customary restrictions.

§ There will be no right, option or obligation provided to the Lessee to purchase the substantial equipment or otherwise guarantee any residual value of the substantial equipment during the term of the lease or at the termination of the lease.

§ The Lessee will be responsible to maintain the substantial equipment at its own expense.

§ Reserve payments will be paid by the Lessee to the Sub-Lessor to ensure funds available for certain activities in relation to the substantial equipment for the lease term. The Lessee may draw on these funds to reimburse the cost of activities incurred by the Lessee during the lease term. Remaining balance will be retained by the Sub-Lessor. The reserve payments will be on-paid to the Head Lessor.

§ The Lessee will, at its own expense, maintain insurance in relation to the use of the substantial equipment.

§ The substantial equipment will be under the exclusive control of the Lessee during the lease term.

§ The rental payments will not be grossed up for withholding tax where applicable, unless there is a change in law in Australian following the commencement of the operating leases.

§ The operating leases contain a tax indemnity clause in respect of taxes arising as a result of the operation of the substantial equipment, subject to broad exclusions.

§ At all times during the term of the Leases, full legal title to the substantial equipment will remain with the Financier, notwithstanding the delivery of the substantial equipment to and the possession and use of the substantial equipment by the Lessee and Sub-Lessees.

§ Delivery of the substantial equipment will take place outside Australia.

At the end of the lease term, the Head Lessor may seek to place the substantial equipment on lease with a new lessee or sell the substantial equipment.

The Leasing Company's structures leases in accordance with its current business model, that is, to offer commercially attractive lease rates to its customers by minimising its costs.

The Lessor has used similar leasing structures in the past.

The rental income does not constitute income listed in subsection 128B(3) of the ITAA 1936.

Assumption

The substantial equipment will be used by the Lessee and its Sub-Lessees wholly in Australia.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 701-1

Income Tax Assessment Act 1997 Subsection 995-1(1)

Income Tax Assessment Act 1936 Subsection 6(1)

Income Tax Assessment Act 1936 Section 128B

Income Tax Assessment Act 1936 Subsection 128B(2B)

Income Tax Assessment Act 1936 Subsection 128B(3)

Income Tax Assessment Act 1936 Subsection 128B(5A)

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1936 Section 177A

Income Tax Assessment Act 1936 Section 177C

Income Tax Assessment Act 1936 Section 177CA

Income Tax Assessment Act 1936 Section 177D

Income Tax Assessment Act 1936 Section 177F

Income Tax Assessment Act 1936 Paragraph 177F(1)(b)

Income Tax Assessment Act 1936 Subsection 177F(2A)

International Tax Agreements Act 1953 Section 4

International Tax Agreements Act 1953 Subsection 4(2)

International Tax Agreements Act 1953 Section 17A

International Tax Agreements Act 1953 Subsection 17A(5)

International Tax Agreements Act 1953 Paragraph 17A(5)(b)

International Tax Agreements Act 1953 - Applicable double tax agreement between Australia and Country A

International Tax Agreements Act 1953 - Applicable double tax agreement between Australia and Country B

Reasons for decision

Issue 1

Australian royalty withholding tax

Question 1.1

Summary

The Sub-Lessor will not be liable under subsection 128B(5A) of the ITAA 1936 to pay withholding tax on the rental payments it receives from the Lessee because the rental payments are not royalties for the purposes of the relevant double tax agreement.

Detailed reasoning

Section 128B of the ITAA 1936 sets out the circumstances in which withholding tax is payable in respect of certain income derived by a non-resident.

Under subsection 128B(5A) of the ITAA 1936, a person (defined in subsection 6(1) if the ITAA 1936 to include a company) who derives income to which section 128B of the ITAA 1936 applies that consists of a royalty is liable to pay income tax upon that income.

Pursuant to subparagraph 128B(2B)(b)(i) of the ITAA 1936, royalty income is subject to withholding tax if it is paid by a resident to a non-resident, except where it is wholly incurred by the payer in carrying on business in a country outside Australia at or through a permanent establishment in that country.

The rental payments payable by the Lessee for the substantial equipment constitute a royalty for the purposes of subsection 6(1) of the ITAA 1936.

In determining liability to Australian income tax on Australian sourced income received by a non-resident, it is necessary to consider not only the income tax laws but also any applicable double tax agreement contained in the International Tax Agreements Act 1953 (Agreements Act).

Subparagraph 17A(5)(b) of the Agreements Act provides that section 128B of the ITAA 1936 does not apply to the payment of a royalty if the relevant Convention does not treat the amount paid as a royalty.

The Sub-Lessor is a resident of Country B. Australia has a double tax agreement with Country B. The Sub-Lessor is entitled to the benefits conferred by the relevant double tax agreement.

The Royalties Article of the applicable double tax agreement deals with the taxation of royalties to which a resident of Australia or the Country B is beneficially entitled. Royalties that fall within the scope of the Royalties Article are defined in that Article. The rental payments in question are not royalties as defined in the Royalties Article.

Accordingly, by operation of paragraph 17A(5)(b) of the Agreements Act, section 128B of the ITAA 1936 will not apply to the rental payments payable by the Lessee to the Sub-Lessor. The Sub-Lessor will not be liable to withholding tax on rental payments payable under the Sub-Lease.

Question 1.2

Summary

The Head Lessor will not be liable under subsection 128B(5A) of the ITAA 1936 to pay withholding tax on the rental payments it receives from the Sub-Lessor because the rental payments are not a loss or outgoing incurred by the Sub-Lessor in carrying on business in Australia at or through a permanent establishment in Australia.

Detailed reasoning

Section 128B of the ITAA 1936 sets out the circumstances in which withholding tax is payable in respect of certain income derived by a non-resident.

Under subsection 128B(5A) of the ITAA 1936, a person who derives income to which section 128B of the ITAA 1936 applies that consists of a royalty is liable to pay income tax upon that income.

Subsection 6(1) of the ITAA 1936 defines a 'royalty' to include an amount paid as consideration for the use of, or right to use any industrial, commercial or scientific equipment.

The terms 'industrial, commercial or scientific equipment' are not defined in the ITAA 1936 or ITAA 1997.

Taxation Ruling TR 98/21 Income tax: withholding tax implications of cross border leasing arrangements explains the meaning of the terms 'industrial, commercial or scientific equipment' in the context of the definition of 'royalty' in subsection 6(1) of the ITAA 1936.

The substantial equipment constitutes industrial, commercial or scientific equipment according to the ordinary meanings of those terms as discussed in TR 98/21 and accordingly, the rental payments payable by the Sub-Lessor to the Head Lessor under the Head Lease are royalties for the purposes of subsection 128(5A) of the ITAA 1936.

Pursuant to subparagraph 128B(2B)(b)(ii) of the ITAA 1936, royalty income is subject to withholding tax if it is paid by a payer who is not a resident to another non-resident and it is an outgoing incurred by the payer in carrying on business in Australia at or through a permanent establishment of that payer in Australia. Accordingly, royalty income received by the Head Lessor will only be subject to withholding tax under subsection 128B(5A) of the ITAA 1936 if the rental payments payable by the Sub-Lessor are an outgoing incurred by the Sub-Lessor in carrying on business in Australia at or through a permanent establishment of the Sub-Lessor in Australia.

Permanent establishment is defined in subsection 6(1) of the ITAA 1936. Taxation Ruling TR 2007/11 Income tax: withholding tax and related implications for a non-resident head lessor or hire purchase provider of substantial equipment where the equipment is obtained by another non-resident entity that subleases, subprovides or leases it for use in Australia, provides guidance on the meaning of permanent establishment for the purposes of subsection 6(1) of the ITAA 1936.

A non-resident sub-lessor who leases substantial equipment to another entity that operates the equipment in Australia, 'has' the substantial equipment for the purposes of paragraph (b) of the definition of permanent establishment subsection 6(1) of the ITAA 1936.

The substantial equipment will be used in Australia by the Lessee. Accordingly, the Sub-Lessor has a permanent establishment in Australia.

Under subparagraph 128B(2B)(b)(ii) of the ITAA 1936, rental payments the Head Lessor will receive under the Head Lease will be subject to royalty withholding tax only if the Sub-Lessor is carrying on business in Australia at or through the permanent establishment in Australia. Taxation Ruling 2007/11 provides guidance on determining whether or not a sub-lessor under a head lease is carrying on business at or through a permanent establishment. The Sub-Lessor will not be carrying on business in Australia at or through the permanent establishment in Australia if the lease contracts between the Sub-Lessor and the Head Lessor are entered into outside Australia and no other activities, apart from the receipt of lease rentals, are conducted by the Sub-Lessor in Australia.

The Head Lease and Sub-Lease are both negotiated and executed outside Australia and no other activities of the Sub-Lessor apart from receiving rental payment from the Lessee arise in Australia.

Accordingly, the Sub-Lessor will not be carrying on business at or through the permanent establishment in Australia for the purposes of subparagraph 128B(2B)(b)(ii) of the ITAA 1936 and therefore the Head Lessor will not be liable under subsection 128B(5A) of the ITAA 1936 to royalty withholding tax on rental income it receives from the Sub-Lessor under the Head Lease.

Issue 2

Australian sourced income

Question 2.1

Summary

The rental payments the Sub-Lessor receives from the Lessee will not be assessable under section 6-5 of the ITAA 1997 because the Sub-Lessor does not have a permanent establishment in Australia for the purposes of the Business Profits Article of the Country B DTA.

Detailed reasoning

Subsection 6-5(3) of the ITAA 1997 provides that the assessable income of a non-resident taxpayer includes the ordinary income derived directly or indirectly from all Australian sources during the income year.

Under section 6C of the ITAA 1936, royalties paid to a non-resident by an Australian resident are deemed to have an Australian source for the purposes of section 6-5 of the ITAA 1997, except to the extent that the royalties are an outgoing incurred by the Australian resident payer in a business carried on by it outside Australia or through a permanent establishment.

Subsection 6(1) of the ITAA 1936 defines a 'royalty' to include an amount paid as consideration for the use of, or right to use, any industrial, commercial or scientific equipment. On the facts the rental payments constitute a royalty for the purposes of subsection 6(1) of the ITAA 1936.

Notwithstanding the provisions of the ITAA 1936 and ITAA 1997, it is necessary in the present case to consider any applicable double tax agreement contained in the Agreements Act.

The Sub-Lessor is a resident of Country B for tax purposes and is entitled to the benefits conferred by the Country B DTA. Pursuant to the Business Profits Article of the Country B DTA, the business profits of the Sub-Lessor will be taxable only in Country B unless the Sub-Lessor carries on a business through a permanent establishment in Australia.

The term 'permanent establishment' is defined in the Permanent Establishment Article of the Country B DTA to mean a fixed place of business through which the business of the enterprise is wholly or partly carried on. Pursuant to the Permanent Establishment Article, a Country B resident is deemed to have a permanent establishment in Australia and to carry on business through that permanent establishment if it maintains substantial equipment for rental or other purposes within Australia (excluding equipment let under a hire-purchase agreement) for a specified period of time.

The permanent establishment deeming provision requires that the Sub-Lessor 'maintains the substantial equipment for rent or other purposes within Australia'.

Based on the ordinary meaning of the terms within the expression 'maintains … for rental or other purposes … within Australia' and the context in which the expression is used in the Permanent Establishment Article of the Country B DTA, the Commissioner considers the expression applies to situations where the actions of a Country B lessor enterprise are directed toward keeping its substantial equipment present within Australia for leasing purposes.

The Sub-Lessor does not maintain substantial equipment within Australia because it does not:

(a) direct or otherwise require that the substantial equipment be used by the Lessee (and its sub-lessees) within Australia, nor

(b) already have substantial equipment located within Australia which is available for lease in Australia, and the equipment is used within Australia.

Accordingly, the Sub-Lessor does not have a deemed permanent establishment under the Permanent Establishment Article of the Country B DTA and therefore, the rental income derived by the Sub-Lessor will not be subject to Australian income tax under subsection 6-5(3) of the ITAA 1997.

Question 2.2

Summary

The rental payments the Head Lessor receives from the Sub-Lessor are assessable under section 6-5 of the ITAA 1997 because the rental payments are royalties for the purposes of the Royalties Article of the Country A DTA and by virtue of the Source of Income Article of that double tax agreement, the royalties are deemed to have an Australian source.

Detailed reasoning

Subsection 6-5(3) of the ITAA 1997 provides that the assessable income of a non-resident taxpayer includes the ordinary income derived directly or indirectly from all Australian sources during the income year.

The term 'Australian source' is defined in subsection 995-1(1) of the ITAA 1997 which states ordinary income or statutory income has an Australian source if, and only if, it is derived from a source in Australia for the purposes of the ITAA 1936.

Section 6C of the ITAA 1936 prescribes rules for determining when royalties paid or credited to a non-resident are to be treated as being derived from sources in Australia.

Subsection 6C(2) of the ITAA 1936 states for the purposes of sections 6-5 and 6-10 of the ITAA 1997, that income to which this section 6C applies shall be deemed to have been derived from a source in Australia.

Pursuant to paragraph 6C(1)(b) of the ITAA 1936, the rules in section 6C apply to income that is derived by a non-resident and consists of royalty that is paid or credited to the non-resident by a person who is a non-resident and is, or is in part, an outgoing incurred by that person in carrying on business in Australia at or through a permanent establishment of that person in Australia.

On the facts, the Sub-Lessor will not be carrying on business in Australia at or through a permanent establishment in Australia.

However, paragraph 19 of Taxation Ruling TR 2007/11 states that where a payment is not subject to a royalty withholding tax liability by virtue of paragraphs 12 and 13 of TR 2007/11, the payment will still be taxable in the hands of the head lessor on an assessment basis under subsection 6-5(3) of the ITAA 1997 if a tax treaty applies such that:

a) the non-resident sub-lessor has a deemed permanent establishment in Australia under the tax treaty;

b) the Royalties Article includes payments for the use of industrial, commercial or scientific equipment (equipment royalties) within the definition of royalties; and

c) the Source of Income Article deems the equipment royalty to have a source in Australia for the purposes of Australia's domestic tax law provisions.

Paragraph 91 of TR 2007/11 further states that a non-resident head lessor will be liable to income tax in Australia under subsection 6-5(3) of the ITAA 1997 if the following conditions are met:

§ the non-resident head lessor is a resident of a tax treaty country that contains provisions corresponding to either Article 5(4)(b) or Article 5(8) of the Vietnamese Agreement, which results in a non-resident sub-lessor being deemed to have a permanent establishment in Australia for the purposes of the Royalties Article;

§ the Royalties Article of the relevant tax treaty includes payments for the use of industrial, commercial or scientific equipment (equipment royalties) within the definition of royalties;

§ the Royalties Article deems the equipment royalty (being a liability incurred in connection with, and borne by, the non-resident sub-lessor's deemed permanent establishment in Australia) to 'arise' in Australia and accordingly allocates Australia a right to tax the royalty; and

§ due to this Australian taxing right, the Source of Income Article of the relevant tax treaty deems the equipment royalty to have a source in Australia for the purposes of Australia's domestic tax law provisions.

The Country A DTA falls for consideration on the facts of this case.

The Country A DTA contains an equivalent provision that corresponds to Article 5(4)(b) of the Vietnamese Agreement. The substantial equipment will be used by the Lessee and its sub-lessees in Australia in carrying on its business. As such, by virtue of the Permanent Establishment Article of the Country A DTA, the Head Lessor will be deemed to have a permanent establishment in Australia for the purposes of the Royalties Article.

The Royalties Article of the Country A DTA provides that the term royalties in that Article means payment or credits to the extent to which they are made as consideration for the use of, or the right to use, any industrial, commercial or scientific equipment. The Royalties Article of the Country A DTA further provides that royalties shall be deemed to arise in Australia where the Sub-Lessor, whether a resident of Australia or not, has in Australia a permanent establishment in connection with which the liability to pay royalties was incurred, and the royalties are borne by the permanent establishment.

The substantial equipment in question constitutes industrial, commercial or scientific equipment for the purposes of the Country A DTA. By virtue of the Royalties Article of the Country A DTA and the Sub-Lessor's deemed permanent establishment (within the meaning of that term in subsection 6(1) of the ITAA 1936) in Australia, royalties are deemed to arise in Australia and accordingly the relevant Agreement allocates Australia a right to tax the royalty. As such, in accordance with the Sources of Income Article of the Country A DTA the rental payments payable by the Sub-Lessor shall be deemed to be income from Australian sources.

Therefore, rental income derived by the Head Lessor pursuant to the Head Lease will be assessable in Australia under subsection 6-5(3) of the ITAA 1997.

Issue 3

Question 3.1

Summary

The Head Lessor is entitled to deduct under section 40-25 of the ITAA 1997 an amount equal to the decline in value for an income year of the substantial equipment it holds for any time during the year.

Detailed reasoning

Division 40 of the ITAA 1997 provides a deduction for the decline in value of a depreciating asset you hold, to the extent that the asset is used for a taxable purpose (section 40-25 of the ITAA 1997).

More specifically, subsection 40-25(1) of the ITAA 1997 provides that you can deduct an amount equal to the decline in value for an income year (as worked out under Division 40 of the ITAA 1997) of a depreciating asset that you held for any time during the year.

The term 'depreciating asset' is defined in section 40-30 of the ITAA 1997. Subsection 40-30(1) defines 'depreciating asset' to mean an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. The substantial equipment is a depreciating asset for the purposes of section 40-25 of the ITAA 1997 and is used for a taxable purpose.

The table in section 40-40 of the ITAA 1997 identifies who holds a depreciating asset. Generally, unless an item of the table provides otherwise, the legal owner of the depreciating asset is the holder (item 10 of the table). Item 6 of the table in section 40-40 of the ITAA 1997 is of relevance to the facts of this case.

Broadly, the effect of item 6 of the table in section 40-40 of the ITAA 1997 applying to an arrangement is that the entity in possession of the asset is taken to hold the depreciating asset for the purposes of Division 40 of the ITAA 1997, and the legal owner is not the holder.

The Head Lessor does not have possession of the substantial equipment and as such, it is necessary to consider whether the Head Lessor has a right to immediate possession of the substantial equipment.

What is meant by a right to immediate possession is explained by paragraph 1.33 of the Revised Explanatory Memorandum to the New Business Tax System (Capital Allowances Bill 2001. Broadly, the economic owner's right to possession must be unconditional, non-contingent and there must not be any thing to be done before that economic owner has the right to gain actual possession of the asset.

As the Sub-Lessor does not have the right to acquire the substantial equipment during or at the end of the lease term and the Head Lessor intends to exercise its option to acquire the substantial equipment at the end of the Finance Lease, the Head Lessor has the requisite immediate right to possession of the substantial equipment.

The Finance Lease from the Financier to the Head Lessor constitutes a hire purchase agreement for the purposes of subsection 995-1(1) of the ITAA 1997.

Division 240 of the ITAA 1997 treats a hire purchase agreement as a sale of goods, combined with a loan, for Australian income tax purposes. Subsection 240-20(1) of the ITAA 1997 provides that the notional seller is taken to have disposed of the property by way of sale to the notional buyer and the notional buyer is taken to have acquired it at the start of the arrangement.

In the present context, the 'notional seller' is the Financier and the 'notional buyer' is the Head Lessor pursuant to section 240-17 of the ITAA 1997

Taxation Ruling TR 2005/20 Income tax: the interaction of deemed ownership under Division 240 of the Income Tax Assessment Act 1997 with the 'holding' rules in Division 40, considers when a taxpayer who is taken to own goods under Division 240 of the ITAA 1997 will be taken to 'hold' a depreciating asset for the purposes of Division 40 of the ITAA 1997.

Paragraph 6 of TR 2005/20 states that a taxpayer (the notional buyer) who is taken to be the owner of goods under subsection 240-20(2) of the ITAA 1997 will not be the holder of the goods for the purposes of Division 40 of the ITAA 1997, unless it is reasonable to conclude that the notional buyer will acquire the asset, or that the asset will be disposed of at the direction, and for the benefit of, the notional buyer.

On the facts, it is reasonable to expect the Head Lessor to acquire the substantial equipment from the Financier. The Head Lessor has a right to immediate possession pursuant to the Head Lease. Accordingly, the Head Lessor holds the substantial equipment under item 6 of the table in section 40-40 of the ITAA 1997 and will be entitled to deduct under section 40-25 of the ITAA 1997 an amount equal to the decline in value for an income year of the substantial equipment it holds for any time during an income year.

Issue 4

Question 4.1

Summary

The Head Lessor is entitled (subject to the Australian thin capitalisation provisions in Division 820 of the ITAA 1997) to deduct under section 8-1 of the ITAA 1997 the interest component of the payments payable to the Financier under the Finance Lease.

Detailed reasoning

Broadly, section 8-1of the ITAA 1997 allows a deduction for a loss or outgoing incurred in gaining or producing assessable income that is necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income except to the extent that such loss or outgoing is of capital or a capital nature.

Taxation Ruling TR 95/25 Income tax: deductions under section 8-1 of the Income Tax Assessment Act 1997 following FC of T v Roberts; FC of T v Smith outlines the general principles governing deductions under section 8-1 of the ITAA 1997.

Expenditure will be deductible under section 8-1 of the ITAA 1997 if its essential character is that of expenditure that has a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income, provided that the expenditure is not of a capital, private or domestic nature.

In determining the deductibility of a loss or outgoing regard should be had to all the objective circumstances surrounding the incurring of the loss or outgoing and in some circumstances the subjective purpose of the taxpayer may also be relevant.

The Finance Lease was entered into by the Head Lessor for the purpose of acquiring substantial equipment to enable it to carry on its business of leasing substantial equipment for the purpose of gaining or producing its assessable income. There is the necessary connection between the outgoing and the business for the purpose of the second limb of subsection 8-1(1) of the ITAA 1997, and the outgoing is not of a kind referred to in subsection 8-1(2) of the ITAA 1997. Accordingly, the interest component of the amounts payable by the Head Lessor to the Financier will be deductible under section 8-1 of the ITAA 1997.

Question 4.2

Summary

The Head Lessor is entitled to deduct under section 8-1 of the ITAA 1997, when incurred, legal costs associated with negotiating and drafting the lease agreements and management costs associated with the leasing of the substantial equipment.

Detailed reasoning

Broadly, section 8-1 of the ITAA 1997 allows a deduction for a loss or outgoing incurred in gaining or producing assessable income that is necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income except to the extent that such loss or outgoing is of capital or a capital nature.

TR 95/25 considers the general principles governing deductions under section 8-1 of the ITAA 1997.

Legal costs incurred for the purpose of negotiating and drafting the lease agreements and management costs incurred in relation to the leasing of the substantial equipment are sufficiently connected to the business carried on by the Head Lessor in gaining or producing its assessable income. The costs are not a loss or outgoing of capital, or of a capital nature. Accordingly the Head Lessor is entitled to deduct under section 8-1 of the ITAA 1997, the legal costs associated with negotiating and drafting the lease agreements and management costs associated with leasing the substantial equipment.

Issue 5

The following reasons for decision apply for questions 5.1, 5.2 and 5.3.

Summary

The Commissioner will not exercise the discretion under section 177F of the ITAA 1936 to cancel a tax benefit that was obtained, or would but for section 177F of the ITAA 1936 be obtained in connection with the relevant schemes because it cannot be reasonably concluded that a person entered into the schemes for the dominant purpose of enabling the Head Lessor or Sub-Lessor to obtain the relevant tax benefit in connection with the schemes.

Detailed reasoning

Part IVA of the ITAA 1936 (Part IVA) is a general anti-avoidance provision. Subsection 177F(1) of the ITAA 1936 gives the Commissioner the discretion to cancel a tax benefit obtained or that would, but for section 177F of the ITAA 1936 be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

Before the Commissioner can exercise the discretion in section 177F of the ITAA 1936, the requirements of Part IVA must be satisfied. Broadly, the requirements are:

(i) a scheme, as defined in section 177A of the ITAA 1936 was carried on by the taxpayer

(ii) a tax benefit, as identified in section 177C of the ITAA 1936, was or would, but for subsection 177F(1) of the ITAA 1936, have been obtained in connection with the scheme, and

(iii) having regard to section 177D of the ITAA 1936, it is reasonable to conclude that the sole or dominant purpose of the scheme was to obtain the tax benefit.

Scheme

The term 'scheme' for the purposes of Part IVA is defined in subsection 177A(1) of the ITAA 1936.

This definition of 'scheme' is broad. It allows the concept of 'scheme' to be cast on a wide or narrow basis. It encompasses not only a series of steps but also the taking of one step. A step or steps in a wider scheme could comprise a narrower scheme however the isolated steps must themselves constitute a scheme. A scheme, as defined, is wide enough to cover a series of interrelated acts by a person or persons over a period of time and can also include the failure to do something. Whether a scheme is wider or narrower should not be relevant in determining if the test in section 177D of the ITAA 1936 is met with respect to the scheme.

Tax benefit

Paragraph 177D(a) of the ITAA 1936 requires that the taxpayer obtain a 'tax benefit' in connection with the scheme. Subsection 177C(1) of the ITAA 1936 provides the meaning of the phrase 'the obtaining by a taxpayer of a tax benefit in connection with a scheme'.

Subsection 177C(1) of the ITAA 1936 defines four kinds of tax benefit, relating broadly to:

a) an amount not being included in the assessable income of the taxpayer for a year of income

b) a deduction being allowable to the taxpayer in relation to a year of income

c) a capital loss being incurred by the taxpayer during a year of income

d) a foreign tax credit being allowable to the taxpayer.

A tax benefit can also arise for the purpose of section 177CA of the ITAA 1936 if a taxpayer is not liable to pay withholding tax on an amount where, but for the scheme, the taxpayer would have or could reasonably be expected to have been liable to pay. Section 177CA of the ITAA 1936 does not require that a withholding tax liability is actually reduced. It is sufficient that there is a reasonable expectation that but for the scheme, the relevant amount would have been subject to withholding tax.

For the purposes of subsection 177C(1) of the ITAA 1936, a tax benefit is obtained in connection with a scheme if the relevant tax benefit:

§ would not have been obtained if the scheme had not been entered into or carried out, or

§ might reasonably be expected not to have been obtained if the scheme had not been entered into or carried out ('reasonable expectation test')

Where it is possible to say that a tax benefit would not have been obtained but for the scheme, it is not necessary to refer to the reasonable expectation test.

Counterfactual

The identification of a tax benefit necessarily requires consideration of the income tax consequences, but for the operation of Part IVA, of an 'alternative hypothesis' or 'counterfactual'. This is what would have happened or might reasonably be expected to have happened if the particular scheme had not been entered into or carried out.

A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable.

If a tax benefit is obtained in connection with a scheme that also achieves a wider commercial objective (disregarding the tax benefit), then it is reasonable to expect that in the absence of the scheme the wider objective would still have been pursued by the means of a transaction or dealing with a different form or shape.

Dominant purpose

The counterfactual(s) also forms the background against which an objective conclusion as to purpose of a person occurs in accordance with section 177D of the ITAA 1936.

For Part IVA to apply to a scheme in connection with which the taxpayer obtained a tax benefit, it is necessary to conclude, having regard to the factors in paragraph 177D(b) of the ITAA 1936 that the person who entered into or carried out the scheme, or any part of it, did so for the 'purpose' of enabling the taxpayer to obtain the tax benefit. The test refers to the purpose of the person (or one of the persons) that entered into or carried out the scheme, or any part of the scheme. That person need not be the taxpayer obtaining a tax benefit. Pursuant to subsection 177A(5) of the ITAA 1936, 'purpose' includes the dominant purpose where there are two or more purposes.

It is possible for Part IVA to apply notwithstanding that the dominant purpose of obtaining the tax benefit was consistent with the pursuit of commercial gain. The key issue is whether the particular scheme, or any part of it, was entered into or carried out by any person for the relevant purpose having regard to the factors in paragraph 177D(b) of the ITAA 1936.

The consideration of purpose or dominant purpose under paragraph 177D(b) of the ITAA 1936 requires an objective conclusion to be drawn. The conclusion required is the conclusion of a reasonable person based on all the facts and evidence that are relevant to considering the paragraph 177D(b) of the ITAA 18936 factors. The factors provide the context in which the dominant purpose of the scheme is to be considered. Such consideration involves comparison of the scheme with the 'alternative hypothesis', that is, the counterfactual.

Broadly, the factors consist of three overlapping sets:

§ how the scheme was implemented

§ the effect of the scheme, and

§ the connection between the taxpayer and other persons.

While the factors in paragraph 177D(b) of the ITAA 1936 will not be equally relevant in every case, each of the factors are taken into account and weighed together in arriving at a conclusion as to dominant purpose.

The issue in question here is whether or not the Commissioner will exercise a discretion under section 177F of the ITAA 1936. Accordingly, the Commissioner must consider whether or not a tax benefit has been obtained, or would but for section 177F of the ITAA 1936 be obtained, by a taxpayer in connection with a scheme to which Part IVA applies. For present purposes, the Commissioner is asked to consider the application of Part IVA to the following specific circumstances (the relevant schemes);

1. a tax benefit that is referable to a rental income obtained, or that would but for section 177F of the ITAA 1997 be obtained by, the relevant taxpayer in connection with any of:

a) the Head Lease from the Head Lessor to the Sub-Lessor

b) the Sub-Lease from Sub-Lessor to the Lessee

c) the Head Lease from the Head Lessor to the Sub-Lessor and Sub-Lease from Sub-Lessor to the Lessee

2. a tax benefit that is referable to a deduction allowable, or that would but for section 177F of the ITAA 1997 be allowable, to the relevant taxpayer in connection with any of:

a) the Head Lease from the Head Lessor to the Sub-Lessor

b) the Head Lease from the Head Lessor to the Sub-Lessor and Sub-Lease from Sub-Lessor to the Lessee

3. a tax benefit that is covered by section 177CA of the ITAA 1936 obtained, or that would but for section 177F of the ITAA 1936 be obtained by the relevant taxpayer in connection with any of:

a) the Head Lease from the Head Lessor to the Sub-Lessor

b) the Sub-Lease from Sub-Lessor to the Lessee

c) the Head Lease from the Head Lessor to the Sub-Lessor and Sub-Lease from Sub-Lessor to the Lessee.

The mere identification of a tax benefit is not sufficient for Part IVA to apply. It is necessary for the tax benefit to have been obtained in connection with the scheme. This requires a consideration of the counterfactuals.

For present purposes, it is relevant to consider the counterfactuals from the perspective of the Leasing Company and its subsidiaries the Head Lessor and Sub-Lessor as a whole. Having regard to the ultimate commercial outcome of the scheme and standard industry behaviour, it is reasonable to accept on the facts that a counterfactual could be either:

§ direct lease from Country A; or

§ direct lease from Country B.

The relevant tax benefits are consistent with the pursuit of the Leasing Company's wider commercial objective. On an objective view it cannot be concluded that the relevant taxpayer obtained a tax benefit in connection with the schemes for the purpose of Part IVA. It is therefore not strictly necessary to have regard to the factors in paragraph 177D(b) of the ITAA 1936 to determine whether the relevant schemes are entered into for the dominant purpose of obtaining the relevant tax benefits. While it is unnecessary to consider the paragraph 177D(b) of the ITAA 1936 factors separately, an analysis of the available facts and circumstances against the factors as a whole indicates that the Leasing Company and the relevant taxpayers will not enter into or carry out the relevant schemes with the requisite dominant purpose.

The facts support a reasonable view that the entering into of the schemes is a straightforward and usual way of achieving the commercial outcomes sought by the relevant taxpayers and the overall transaction is not considered blatant, artificial or contrived.

Accordingly, Part IVA will not apply and the Commissioner will not exercise a discretion under section 177F of the ITAA 1936 to cancel a relevant tax benefit obtained in connection with the relevant schemes.